Question

Link equity valuation to discounted cash flow models. In theory, is it similar, different? Link the Price/Earnings Ratio to Growth Opportunities, using today’s S&P500 Index as an example. How are FCFF and FCFE defined? What does “consistency” refer to in valuation theory?

Please write out answers in detail so I can understand

Answer 1

FCFE: Free cash flow for equity

PAT: Profit after tax

Dep: depreciation: Dep is added back to PAT as it is a noncash expense.

FC: Change in net fixed capital investment, if money is spent on fixed assets then it is positive & vice-versa

WC: Change in working capital (inventories + receivables - payables). If WC is increased then it is positive & vice-versa

Debt: If debt is raised by the firm, then it is positive or if it is paid back, it is negative.

Ke: cost of equity

V: Valuation of equity of the firm

Where FCFE1: is the free cash flow to equity for 1 year after 1 year from now

FCFE2: is the free cash flow to equity for 1 year after 2 years from now and so on

FCFF: free cash flow for the firm

EBIT: Earnings before interest & tax

F: Value of the firm

WACC: Weighted average cost of capital

Where FCFF1: is the free cash flow for firm for 1 year after 1 year from now

FCFF2: is the free cash flow for firm for 1 year after 2 years from now and so on

F = D + V

where D is the market value of debt

V: value of equity

V = F - D

Both FCFE & FCFF are discounted cash flow methods for the valuation of equity. In theory, both are different

P/E ratio: price to earnings ratio (1 year trailing)

P/E ratio = (Current price per share)/(Last 1 year earnings per share)

The higher the P/E ratio, the higher the valuation premium of the firm

PEG ratio: (P/E ratio)/(Project annual earnings growth rate)

The higher the projected annual earnings growth rate for the firm, the higher the P/E valuation, i.e. you will have to pay high premium for a company with high growth rate

Consistency in valuation means has the company been consistent in its actual earnings when compared to its projected earnings. If a company shows consistency, then it will have a higher P/E valuation